Get ready for steep rate hikes in 2011: economist

September 11, 2009

Paul Vieira, Financial Post

OTTAWA — When the Bank of Canada does start raising its key policy interest rate in either late 2010 or early 2011, Canadians should brace for “aggressive” increases of up to a percentage point at a time, says a report from the chief economist at Laurentian Bank Securities.

The call, from Carlos Leitao, adds a new wrinkle to the debate as to whether the central bank will be able to keep its pledge to leave its key policy rate at 0.25%, or the lowest level possible, until June 2010 in an effort to stimulate the economy. This analysis kicks off a debate in terms of how aggressively the central bank needs to act once it believes rate increases are in order.

The Montreal-based economist said he believes Mark Carney, the Bank of Canada governor, will be able to keep his June 2010 promise, based on the amount of spare capacity in the economy and continuing job losses that are likely to peak early next year.

The Bank of Canada is likely to begin hiking rates after unemployment peaks (in early 2010) and before inflation hits the preferred 2% target (sometime in mid-2011). Once that period comes, Canadians should prepare for steep rate hikes.

“An aggressive tightening – rather than a gradual one — will be necessary because rates are extremely low,” Mr. Leitao said in LBS’s weekly note to clients released Wednesday. “A ‘measured pace’ would not be appropriate to ‘normalize’ rates when the starting point is virtually zero.”

Analysts say one of the key causes of the financial crisis was that the U.S. Federal Reserve kept its key policy rate too low for too long. When it did begin raising rates in 2004, they say, the Fed opted by gradual increases of 25 basis points – not nearly aggressive enough, in retrospect, to cool down the white-hot housing bubble that resulted in the financial market meltdown almost a year ago.

Mr. Leitao said should the Bank of Canada take a similar path like the Fed did earlier this decade, its key policy rate would be at just over 3% by the end of 2011.

“This could well prove to be too low for an economy that would be running at a decent pace with inflation already at the 2% target,” he said. “This means we are likely to see a mix of 50, 75 and even 100 basis points hikes — when the time comes.”

The Bank of Canada releases its latest interest-rate statement on Thursday, and analysts are near unanimous that it is unlikely to contain much change. The central bank will leave its target rate unchanged and reiterate its commitment to leave it there until mid-2010.